Banks have progressed from being providers of mass-market products to being providers of products designed to appeal to a variety of niche markets. We're now seeing the logical extension of that progression in the movement toward one-to-one marketing.
This latest shift has also intensified the debate over whether to calculate profitability at the account level.
Those favoring this approach reason that if an institution wants to increase profits, customers must be targeted for product or service enhancements based on their contributions to the bottom line.
But others wonder why there is this great debate when we all know it's simply revenues minus expenses.
In fact, calculating and assigning expenses at the account level, though theoretically simple, is difficult in practice. On the other hand, determining revenue is fairly easy.
For different financial products, income can be calculated in a straightforward manner: For a credit card, count fees, finance charges, and interchange income; for lines of credit and loans, count fees and finance income; for demand deposit and savings accounts, count fees and investment value of retained deposits; and for investment products like mutual funds, count fees and commissions.
On the other side, calculating and allocating expenses at the account level is not only complex, but often subjective.
Starting with the simplest elements first, some costs that can be accurately calculated at an account level include: remittance, transaction, and statement processing costs; dunning and collection expenses; cost of funds; and chargeoff expenses.
Cost of Customer Service
But how do we calculate account-level expense for customer service?
Virtually no financial institution calculates and records the amount of customer service hours actually expended per account. While it's true that almost all systems retain a list of disputes or adjustments that could be converted into estimated expended time, only a fraction of customer service activity results in a dispute or adjustment.
From what I've seen, customer service expense is allocated in a number of ways. Sometime it's allocated to active accounts. But this calculation assumes all active accounts use customer service equally.
Sometimes costs are allocated to the total number of accounts. But this suffers from the same problem as active account allocation.
Finally, to calculate according to the number of disputes or adjustments per account would be misleading because this type of activity represents only a fraction of all activity on an account. Furthermore, a customer may have called regarding a problem created by the institution.
Data processing, overhead, and other huge expenses, including advertising and promotion expenses, are subject to similar problems in determing accurate allocation.
At some time in the future, after expending a great deal of time and money, a method may be developed for accurately allocating these expenses. Before all the time and effort required is expended, we should ask ourselves whether the end product is worth it.
The expenses are so large that assigning them can easily make an account go from profitable to unprofitable, unfairly and for no good reason.
And, unless you have error-proof technology systems, customers could be charged for errors and inefficiencies caused by the institution. That definitely doesn't make sense.
Ignore that Calculation
What's the solution? My recommendation is that overhead and customer service expenses be ignored at the account level. A flat allocation based on open or total accounts will reduce each account's profit by a constant amount.
For targeting purposes, accounts could be selected based on whether they produce a certain level of profits.
While expensive research can establish the "true" costs of all functions, it should not be used to assess account level profitability.
The costs of operations processing, customer service, and other corporatewide expenses should remain part of the institution's cost of doing business.